The Fed's Big Shift

When it comes to stimulating the U.S. economy and fiscal policy, we seem to be on track to shift away from using monetary policy as the principal tool.

For a year now, the Federal Reserve has been consistently telegraphing its intention to taper quantitative easing, and to eventually normalize the fed funds rate on what appears to be a predetermined course -- and with little consideration for what the economy does in the interim. At this point there appears to be broad consensus among Fed governors and bank presidents, as well as among former and current Fed chairs, that the prime monetary goal now is to normalize interest rates on U.S. Treasury bonds.

Meanwhile, last week's April personal income and outlays report (PDF), issued the Bureau of Economic Analysis, came in below expectations, as has been the case for most economic reports this year. The Chicago purchasing managers index (PDF) showed economic improvement, but the April income and sales figures imply a second-quarter real annualized GDP growth rate of 2.1%, well below the consensus estimates of 3.3%. The report also indicates annualized real final sales growth of just 1.4% vs. the 2% long-term average, and 0.7% per capita. Note that, historically, when per-capita sales growth is below 1% real, the economy is already in recession.

But, at this juncture, here's the important issue as it concerns monetary policy: Among Fed governors and presidents who have recently discussed economic activity and monetary policy, no weight whatsoever has been given to these numbers.

It is possible that economic activity will accelerate for May and June, and that GDP growth will therefore meet the consensus estimates. But, even if that doesn't happen, the numbers seem good enough for the economy to have grown in the second quarter. That, in turn, would preclude an official recession, as determined by the National Bureau of Economic Research.

Once again, though, regardless of any of this, the Fed appears to have decided on a profound shift in monetary policy.

Namely, the central bank seems on track to remove QE and normalize interest rates on a predetermined path unless the economy suffers a negative shock of some kind -- and irrespective of whether economic activity accelerates. The Fed also appears to be coordinating with the executive branch, at some level, on shifting to fiscal policy as the prime driver. President Obama's January push for a substantive focus on domestic infrastructure is in keeping with such a shift.

As a matter of fact, U.S. policymakers may be in the nascent stages of adopting the same fiscal policies that have been utilized in China. For the past few decades, China has relied far more on fiscal policy specifically targeted at infrastructure than it has on monetary policy.

What's most interesting about this, as well, is that China's initial choice to adopt this stance was largely predicated on a 1993 academic paper -- "Fiscal Policy in General Equilibrium" (PDF) -- by Robert King and Marianne Baxter, two highly regarded U.S.-based economists. The paper is quite famous in economic circles, and since its publication King has gone on to become one the most influential economists in the world, although he is not well-known outside of the economics community.

In their paper, King and Baxter noted that fiscal spending on infrastructure produces public capital has a greater-than-1 multiplier, both in the near and long term. More important, they note that the multiplier increases as time goes by. That means every dollar the government spends on roads, bridges, airports and so on will produce more than a dollar's worth of private-sector economic activity. It also means the returns increase over time as private-sector participants generate business activity around and in conjunction with the new public infrastructure.

I don't know why U.S. policymakers haven't given this more attention in the past few decades. But this seeming nascent epiphany in the U.S. may have been driven by China's successful adoption of this into its fiscal model. India, as well, is on the verge of adopting the same policy under Narendra Modi's new leadership.

The world may be on the verge of a boom in publicly funded infrastructure.